Tuesday, September 30, 2008

Three weeks before J.P. Morgan bought WaMu's deposits for $1.9 billion, officials at the Federal Deposit Insurance Corp. called J.P. Morgan to say the FDIC was carefully monitoring WaMu and that a seizure of its assets was likely. The FDIC said it would want to immediately auction off WaMu's assets if a seizure was necessary, people familiar with the situation told Deal Journal.

J.P. Morgan was well-prepared, then, when the FDIC asked for bids Tuesday, Sept. 23. On Wednesday night, the regulators told J.P. Morgan the bank had won the bidding, one person close to the situation said.

So, three weeks before WaMu was taken over the FDIC told JP Morgan that they were likely to seize the assets.

A week later the OTC agreed a deal with WaMu (resulting in the change of its CEO) that said

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank’s operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

So WaMu was – according to WaMu’s press release – not required to raise capital, increase liquidity or make changes to the products and services it provides customers.

Now I am aware that the OTS is not the same organisation as the FDIC - but somewhere the government was talking out of both sides of its mouth - and what the FDIC told JPM made it more likely that WaMu would fail to raise capital or find a buyer.

The US is a current account deficit country.Get used to it.You (and I am not an American so I can say you) have been spending more than you earn for years.

I can’t speak too rashly though because Australia and Aoeteroa (New Zealand) – the two countries to which I am closest – are also current account deficit countries.

If you run a current account deficit for long enough your financial system will be NET short deposits.There will be (say) 130 of loans for 100 of deposits.[If you are the UK it can be much more extreme – with Northern Rock having a loan to deposit ratio of a few hundred.] Individual banks will have sufficient deposits but everyone is vulnerable.

Banking can be profitable even if you are short deposits.Indeed it was silly-profitable for more than a decade before the insane lending started.The high levels of profitability meant that people would lend to banks unsecured in quantity at thin spreads.

Banks became totally dependent on their ability to roll the loans.If they can’t roll this senior unsecured funding they will fail.No ifs, no buts.That results in failure.

Most banks in current account deficit countries have such funding.In Australia it is called Bank Bills.Here it is called lots of names only because financial innovation has found lots of ways to name the same stuff.

I have calculated out the losses of banks in the US numerous times – and in no sense are the losses not able to absorbed (at some cost) by the highly productive US economy.There may be a period of austerity as America adjusts – but the economy should bounce back.

Under the presumption it can finance itself.

But it can’t finance itself unless it can assure unsecured lenders that it is a sensible place to lend.

The end of this financial crisis will occur when unsecured lenders feel safe lending to financial institutions again.If this does not happen the crisis will not end – and there will be a great-depression level event in the US.That is real – factories will be idle, and good people will be roaming looking for jobs and unable to feed their children.

So I am going to set up policy guideline here for a bailout and for all FDIC action.All policy should be geared towards making unsecured lenders feel safe.New regulation should be geared that way.The takeover of banks will be well done if it gives the appearance of respecting the rights of unsecured lenders.The WaMu deal was bad.The Wachovia one was better (only from the position of an unsecured lender but that is the only position that matters).

America has – through decades of excess spending become beholden to the whims of unsecured lenders.

Face reality.That is who you have to please.

Incidentally the Swedish/Norwegian solution did that but wiped out almost all equity and preferred shareholders.Bank stocks would go down a bundle from here with anything that looks like Scandinavia.

John Hempton

PS.I have no dog in this race.I am short a few bank stocks, long a few preferreds and have no position whatsoever in senior debt of banks.

My view is that the financial crisis will be over when people will lend unsecured to US financial institutions and not before.

Removing the rights of unsecured lenders without appeal hardly aids that cause.The FDIC thus made it much worse.

With Wachovia it was again open to the FDIC to confiscate Wachovia and sell it without the acquirer taking over the obligations to senior bond holders.This would mean that the government would have got away without risk of loss.

Instead Citigroup has assumed those obligations.The FDIC has offered (for a large fee of 12 billion in Citi preferreds) an insurance policy against fat-tail losses at Wachovia.It has – admittedly at some risk to government – not removed rights from the senior.

This is a darn good thing for America because the sooner the government protects the rights of the senior the more likely it is that people will lend again to American financial institutions.And when American financial institutions can borrow again the crisis will be over.

POST SCRIPT: Looking at the deal I think the FDIC has done better than I thought plausible... it will probably get out whole. That said - if anyone believes that if they had not done WaMu on Thursday they would be doing Wachovia on Monday believes things different to me.

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There is little doubt in my mind that Wachovia had more time if the FDIC gave WaMu more time.

The FDIC call on WaMu doomed Wachovia.

The deal - just coming at the moment - has the FDIC essentially issuing guarantees on a very thin balance sheet - and that will probably cost it money.

The FDIC got out of its WaMu problem (and I do not doubt there was a WaMu problem) by confiscating the "run-off value" of many WaMu securities.

But in the process it has made it very difficult to lend to American banks because if you lent in the form of anything other than an FDIC insured deposit you had “fear of government”.The Government could – with minimal evidence and no appeal – confiscate your assets.There is no appeal against pressure applied by the FDIC/OTC and you can have your bank confiscated when it has adequate capital and is still liquid.

Anyway – Wachovia is only the first of many banks that required wholesale funding and which the FDIC has doomed.There are many more.

I don’t want to pick on too many.As Jeff Matthews has pointed out it is not exactly sensible to scream “this sucker could go down”

Sunday, September 28, 2008

I lost money on this – so you can take my analysis with the caveat of a slightly angry grain of salt.

But I still think the seizure of Washington Mutual is the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle. But that takes a little explaining.

Lets do it on a typical current account deficit country bank. In a country with a current account deficit the loan to deposit ratio of the bank is usually something like 130. That is banks in current account deficit countries have more loans than deposits. Banks intermediate the current account deficit. I have blogged about that extensively – see here and here amongst others.

Here would be the typical capital structure of such a bank rebased so that total assets and liabilities equal 100.

I cannot spell out how common this sort of structure is. It would be a typical bank in most current account deficit countries other than that the secured borrowing may be unsecured in other countries. In the US banks can pledge assets to the Federal Home Loan banks – which is secured funding essentially backed by the US Government. In the UK there would be much less equity in the structure than in other jurisdictions. In America slightly more. If I were to rebase the balance sheet the equity in the US would be typically about 8%, in Australia about 7%, in Spain a little thinner and in the UK about 4%. After you adjust for goodwill these numbers are another percent or two lower.

Now generally (and I am talking in good times) the equity was a high return piece that got good returns under the understanding it could go to zero. Every equity holder knew (or at least should have known) that a wipeout was a possibility. The preferred stock was typically a very long dated instrument (say 30 years) with no security whatsoever and a dividend that could be suspended. There usually wasn’t much of it but anyone that thought rationally about it knew it could be wiped out. It also yielded say 500bps more than Treasuries. It was junk at pretty well all banks - though it could sometimes have a fancy rating.

But the senior debt in this structure was often medium dated, yielded say 120bps more than treasuries and was considered pretty safe.

After all – to wipe out the senior debt the equity, preferreds and junior debt needed to go first.

In this example above 12 had to be bad to touch the senior debt and 18 had to be bad for the senior debt to be worthless. As there was only 76 in loans in this table then 18/76 = 23 percent had to be bad. That was before you considered that the business would typically have some pre-tax, pre provisions earnings. So to wipe out the senior debt typically 30% of the loans had to be bad. As most of the loans in most banks in current account deficit countries are mortgages and would have a recovery rate maybe 50% of the loans need to default. With a bank diversified across a country that seems implausible even in these times of mortgage stress.

For the senior debt holders even to be hurt 30% of the loans probably needed to default. It was always possible – but the senior debt holders have (with some considerable intellectual justification) acted as if it were unlikely they would be nicked. They had plenty of protection – provided by equity, preferreds and junior debt.

Now if you notice in this capital structure the difference between loans and deposits – the lending that makes current account deficits countries possible – happens as either secured borrowing or unsecured senior borrowing. In countries without the Federal Home Loan Banks (which provide secured funding) the difference between loans and deposits is funded almost entirely with the senior.

What makes this structure possible is order of creditors and the reliability that governments/liquidators etc will honour that order of creditors and ensure that the senior debt instruments at least (and all the other debt instruments) will get a fair shake when things go pear shaped. If in a liquidation the senior was considered parallel the equity or preferred then the senior wouldn’t exist.

The seniors knew they took a risk. We know that because of the 120bps they charged. But these people think (with some justification) that they took very little risk. They relied for that justification on the notion that governments had rules which shifted the losses where they belonged, on equity, preferreds, juniors and seniors in that order. If they didn’t believe that then all senior funding would disappear and all institutions that were reliant on that senior funding would fail.

Ok – there was a minor bait-and-switch in this post. The ratios that I put out there were Washington Mutual in their final published results as a bank holding company. They are however not atypical – and the variants are fairly described in the following paragraph.

Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds to but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

Except that the liquation rights – well established order-of-creditor rights – were denied by a swift US Government action.

Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made.

Now lets compare the WaMu case with the IndyMac case. In the IndyMac case I think the government acted fairly. The main issue with the IndyMac case is that there is accountability. The government is liquidating the IndyMac loans in full public glare – and it is clear that they have lost (considerable) moneys. The senior debt (if there were much) would know pretty clearly that they were toast because they could see the results of the liquidation.

This visibility is not available in the WaMu case as there is no public liquidation – instead the assets were confiscated and flicked to JPMorgan as part of essentially the same transaction. The confiscation of WaMu would not have happened when it happened if there had not been a simultaneous buyer. So the senior debt holders never got their order of creditors.

The lack of visibility creates a lack of accountability. Sunlight (visibility of the liquidation) is the greatest disinfectant. In the WaMu case senior debt holders from the outside look as if they had their rights taken from them (and those rights were valuable) by a government official without any method whatsoever of auditing the decisions of said official. That is why the actions of the Government were capricious in this case. [Some comments on this blog have wondered why I think it was capricious. I stand by that wording...]

It would of course be more acceptable if there was a large body of evidence that the government put forward to justify their complete disregard for quite senior rights here. The evidence for instance in the Bank of Credit and Commerce International was pretty strong. BCCI was a criminal organisation and the dosh was simply stolen. There were criminal prosecutions. There was sunlight… and so we could be sure that the government acted with justification.

But in this case the Feds did very little to justify their decision. Lets run through some of it.

On September 8 WaMu changed its CEO and announced it had entered a Memorandum of Understanding with the Office of Thrift Supervision.

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank’s operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

Note that the business plan in this press release did not require that the bank either raise capital or increase liquidity. Moreover it did not require that the bank forecast liquidity.

On the 11th of September the bank noted its available liquidity was about 50 billion dollars and that the bank continued to be capitalised significantly above the well capitalised levels.

On the 17th of September the bank confirmed what everyone knew, which was that the bank was for sale. TPG (the private equity group) waved their pre-emption rights with respect to any transaction.

On the 24th of September there were no bidders for the common equity.

On the 25th of September it was taken over.

Now in the middle of this sequence the press became alive with stories about how bad it was at WaMu. Lots of people close to the deal were talking – as I noted in this (unfortunate) post. They were talking their book – that is spreading nasty rumours about WaMu.

We know that there was a run on deposits starting on the 15th of September with a net deposit loss of 16.7 billion. That run was almost certainly triggered by the wave of stories about WaMu and that wave of stories was triggered by investment bankers trying to buy WaMu on the cheap. In other words government action was as responsible as anything else for the run.

Moreover – and nobody has denied this – WaMu had 50 billion in liquidity. Only deposits above 100K will run if the government publicises that FDIC deposits are safe. 50 billion of liquidity less the 16.7 that ran left plenty. Its almost certain that WaMu had sufficient liquidity left to deal with its jumbo deposits. WaMu after all was a retail bank – and jumbo deposits were not the driver.

Now the clincher – in the OTS fact sheet on the WaMu liquidation is this little zinger:

Maintaining Capital – In late 2006 and 2007, WMB began to build its capital level through asset shrinkage and the sale of lower-yielding assets. In April 2008, WMI received $7.0 billion of new capital from the issuance of common stock. Since December 2007, WMI infused $6.5 billion into WMB. WMB met the well capitalized standards through the date of receivership.

Note the OTS thought that – at least as of the date in which they confiscated the bank – it was well capitalised. It was probably also liquid - after all 50 minus 16.7 is a lot when we are talking in billions.

Now the future of WaMu was uncertain. They clearly had plenty of losses coming at them. The company estimated those losses as 19 billion. JPM has estimated 31 billion. On both those numbers incidentally the senior debt holders in WaMu should – in an orderly liquidation – be made whole. Get that – on JPM’s own numbers the senior debt holders should have been made whole – and yet the rights of these debt holders were confiscated.

I don’t know the future, the OTS doesn’t know the future, and JPM doesn’t know the future. Nobody really knows what the end result for WaMu would be in an orderly liquidation. Everyone knew that WaMu was in some trouble. That was clear.

The OTS/FDIC carried a risk – the risk being that the losses would be so large that would wind up costing the government money.

The government solved its problem – and it did it by taking away the rights of the senior debt holders to an orderly liquidation – when on the numbers given by the ultimate acquirer the senior debt was likely to be whole or near to whole.

The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.

This was – by far – the least justified government action of this credit cycle. And it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing because it is so capricious.

Those banks are many – but we can start with Wachovia whose destiny (failure) is now nearly certain – and for whom the precedent is set. But after that we can go for all the banks including the champions such as Bank of America and Citigroup. Creditors now face confiscation of their rights by the US Government without oversight or audit or even process.

At that point there is no creditors and the economy collapses. The trust needed to make capitalism worked has been removed. I am not a conservative - but I will argue - along with many conservatives - that the most important function of government in a capitalist society is provision of a framework by which property rights can be defined and enforced as this is the key to making a capitalist society function. The Government is now acting as if the framework does not apply to them. That is bad whatever your political persuasion.

What next

The FDIC and OTS have won the battle with respect to WaMu. They got rid of WaMu without any cost to the taxpayer. The WSJ lauded that achievement. They really did get out of their WaMu risk quite neatly – and I will bet the heads of those organisations went to bed feeling pretty pleased with themselves.

But in the process they have doomed about two thirds of the US banking system.

I am still a believer that government – whilst not stuck with great incentives will grope for right solutions. But that belief of this former (competent) public servant is being shaken to the core.And whilst Wachovia and dozens of others will eventually hit the wall because of this decision the Government will work out that it has a bad process before Bank of America fails.

But I think it is time that the process is short circuited. The heads of the OTS (John Reich) and of the FDIC (Sheila Bair) should be sacked now and for cause. Mr Paulson better get control of this situation and let it be known that the US has a process for dealing with senior creditors and making sure that their rights are honoured.

Friday, September 26, 2008

Many of my regular and some of my more perceptive readers have asked about Wachovia. To date I have studiously avoided stating my position.

Besides - as is now clear - my views are worth little. I thought WaMu was ultimately better than Wachovia and preferred the preferreds of WaMu to many less risky bets. I did not (and would not) own the common of either institution. I would not - as I think at best they wind up diluting themselves massively. I am fond of shorting commons against preferreds - but that trade is difficult to do these days.

Anway I was wrong. WaMu was confiscated first.

In the past Wachovia has looked worse than WaMu. Does anyone other than me remember the Money Store?

It will not be long before Wachovia's numbers are as bad as WaMu was last quarter.

I have no position in Wachovia but if I could I would short the common now. The way the FDIC acted makes me think Wachovia is toast too.

If you were the CEO of Wachovia you would be looking for a bride-groom or suitor now. You would take a bid at a discount to market so the common is just awful.

The prefs in Wachovia would just be a bet on a willingness of someone to pay 50c a share for the common - and now the FDIC appears willing to confiscate the bank and even wipe out the senior debt there appears no reason to do that.

The FDIC decision might be right - but the public information needed to justify it is simply not there. The FDIC has some explaining to do. [I am - I note - inclined to believe that the decision was well thought through - even if at the moment it looks like a shoot-from-the-hip ambush.]

This is important because if the decisions to wipe-out the claims of debt holders appear arbitrary you ensure that nobody is willing to be a debt holder.

And that - more than anything else - spells big problems for Wachovia. Ultimately it might even spell problems for Bank of America or for America itself.

It can be insolvent but not illiquid – when it has plenty of access to deposit funding but the loans it has made are heavily bad.In this case continued operation risks further losses to depositors and the organisation SHOULD be regulated or confiscated.

It can be illiquid but not insolvent (such as when a perfectly good bank has a run).

The purpose of lender-of-last-resort things in bank regulation are to ensure that banks which are subject to runs don’t fail because they are illiquid but not insolvent.If a bank which is solvent has a run the right thing for the government to do is to front the run – make it go away – and let the bank sort itself out over time.

The problem of course is that when a bank is illiquid it is very hard to tell whether the liquid bank really is insolvent.

If the government were perfect at telling this they would know precisely who to bail out and who not to.Nobody serious thinks they know that.If I knew that I would be a much better stock picker than I am.

Anyway the reason for a bank confiscation is that the bank is UNSOUND meaning the capital is inadequate.Illiquidity is NOT a reason for a bank liquidation.

This comment was made by the FDIC:

Federal regulators said WaMu has suffered an exodus of $16.7 billion in deposits since Sept. 15, leaving the Seattle thrift “with insufficient liquidity to meet its obligations.” As a result, WaMu was in “an unsafe and unsound condition to transact business,” according to the Office of Thrift Supervision.

What is strange about this is that this is precisely the reason you SHOULD NOT take over an institution – certainly without consulting it about alternative forms of liquidity (such as pledging its loans).The whole point of government intervention is to nationalise insolvent institutions and to keep solvent ones liquid. Now I suspect there is more to this story than this blog post. But for the moment the explanations are inadequate...

Two weeks ago WM put out a press release that said this:

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank's operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

If this release was not a direct lie - and there is no reason to believe it was - then the OTS thought only two weeks ago that WaMu did not require additional capital. Very strange indeed.

WaMu's deal team, including Mr. Fishman, left New York on Thursday night and caught a plane back to Seattle, not knowing that the company was about to be taken over by the OTS and sold to J.P. Morgan.

I got a question: is this for real? Is this how the American government now acts?

I would prefer think my post was wrong than the American Government acts in arbitrary capricious ways. If the FDIC took over WaMu whilst the executives were on the plane without discussing the true liquidity situation of the bank first then I fear for all American capitalism.

So - for the moment - I will hope the WSJ story is wrong. I have been wrong plenty of times - so that is not something I should criticise sharply. But this is an intellectual puzzle: what did the FDIC tell WaMu and when? Why did it decide to take over WaMu now?

More is sure to come in the press so I am loathe to speculate. But this is one of the more interesting intellectual puzzles of the past few years.

The common is behaving badly - but as if survival is a small possibility. The common is down 24 percent but is still $1.70 giving it a market cap of 3 billion.

The preferred (K class) is down 28 percent and has a price of $1.64 - a price which compares highly unfavourably to my first purchase at about $6.

There are a few outcomes here:

(a). The FDIC takes over. In this case both the common and preferred is worth zero. If I were looking at the common price I would think that was say 50 percent likely. If I were looking at the preferred price I would say it is more than 90 percent likely. My own analysis suggested that this was less than 30% likely when I purchased - but the market tells me I am wrong. And the walk-out by Santander today is highly discouraging as Santander is often the buyer of last resort.

(b). A solvent bank like JPM buys it for under the current price. In this case the pref should be worth close to par - being an instrument of JPM. The common will lose money.

(c). There is an auction and the bank is purchased at a premium. The market is telling me this is very unlikely - but the common will rise a little bit (say to $3) and the pref will rise a lot (to near par).

(d). The bank muddles through - possibly with the help of the TARP - but it is hard to see how the common ever gets back to 25 (especially if they have to give warrants under the TARP), but the pref winds up fairly good.

(e). They fail instantly and hand themselves to the FDIC - which has the same outcome as (a).

In every one of these circumstances the pref is a at least as good an investment as the common - althought they might both be awful. So far they have both been awful - but I only own the pref.

This sort of mispricing wouldn't exist if it was really easy to short the common. But for the moment anyone who owns the common should sell it and buy the pref.

I am holding my prefs to the bitter end - and the end may be bitter. We find out this weekend.

The truth is, no one really knows what the future of WaMu will be, only that it'll likely be decided within the month. If you're into big-stakes gambling, WaMu's for you. If you have a sliver of financial responsibility in you, enjoy this show from the sidelines.

This sucks. I have a highly speculative bet on Washington Mutual preferred. It runs that I think a takeover is more than 30% likely. It may be a takeover at 50c a share - which would be awful for the common shareholder.

But I thought it pretty likely. If you asked me I would have thought 70% likely. The only problem being that the potential buyers have fires of their own to put out.

Anyway a buy-out by (say) Citi or JPM is not a great end for the common shareholders - but would be wonderful for the preference shareholders.

Nightmare for the preference shareholders is an FDIC takeover which would wipe the prefs as well as the common.

This is of course a wild ass speculative bet.

But here is a possibility that I hadn't thought of - which is a deal involving private equity consortiums. That would not be as good as being a pref shareholder in (say) Citi. I am not sure how legal this would be but these are desperate times - and something could happen.

I suspect the pref would be worth something in this scenario - but I would much prefer the company stick around to take advantage of the Paulson plan.

I am a little afraid here - this deal is becoming problematic. The news that Santander - often the dumbest bank on the block - has pulled out - is not good.

J

Washington Mutual bank explores takeover possibilities: report

4 hours ago

NEW YORK (AFP) — The troubled US bank Washington Mutual has approached certain private equity firms as possible candidates to take it over, the Wall Street Journal reported on Thursday.

The private investment groups approached include Carlyle Group and Blackstone Group, which may team up with Texas billionaire Gerald Ford, the daily said, citing sources familiar with the matter.

Questions have arisen over Washington Mutual's future since last week's dramatic collapse of investment giant Lehman Brothers and the government rescue of insurance group AIG.

Washington Mutual's shares have lost 80 percent of their value since the beginning of 2008. On Wednesday the ratings agencies Standard & Poor's and Fitch lowered their ratings of the bank's holding company.

Press reports have mentioned JP Morgan Chase, Citigroup and Wells Fargo as other banking groups possibly interested in taking over Washington Mutual. The Wall Street Journal said Santander of Spain had dropped out of the running.

Wednesday, September 24, 2008

Jeff Matthews has nailed the essence of the Paulson plan and the Buffett buy in Goldman Sachs in one sentence:

More seriously, we wonder this: how is it that Warren Buffett can cut a better deal with the best-run financial company in America than the U.S. Treasury can ask from the worst-run financial companies in America?

And that is right. Buffett took preference shares and upside. Paulson does not plan to.

I have started getting a wave of comments promoting commercial services in debt consolidation, mortgage workout and the like.

I delete these.

I accidentally deleted a useful comment on the oil short-squeeze - but that was because it was bracketed by spam. To the author - I am sorry.

I have also received a wave of comments accusing all short-sellers of being criminals. I know that view is out there. But it is hardly constructive to repeat it here. So I deleted them (at least in part because of the aggressiveness of the commentary). However in fairness in keeping with this blogs policy of encouraging open comment I will at least tell you that the argument covers the full gamut of arguments against short-sellers and you can find them at the Sanity Check and other "anti-short-selling" websites.

My experience is that most people that argue against short sellers are in fact fraudsters - and they don't like that shortsellers profit from the falls in their stock. But I will listen to other arguments.

Against that Ameribank had slightly more deposits than loans and so liquidity was not a huge issue.

WaMu’s book is MUCH better than Ameribank – but unfortunately WaMu has much more deposits than loans and hence liquidity is and issue.

Pretty well my entire email inbox says I am mad buying the preferred of WaMu.I may well be.

And here I would love a little birdie to tell me what the FDIC is thinking.And all I can rely on is my friends from the fourth estate.

So we go to a little article on WaMu and the FDIC.This is in that wonderful little journal called “The Deal”, and is really the unsubstantiated gossip from investment bankers who are working on WaMu deals – or people who know investment bankers who are working on WaMu deals.You can bet that every “source” is talking their book meaning they are trying to lobby government officials, WaMu officials, other investors or whatever to act in a way favourable to themselves.

The sale of troubled thrift Washington Mutual Inc. looks set to come to a head this weekend, according to sources. One source said WaMu could choose a buyer by Thursday, Sept. 25, and announce a deal this weekend.

There are so many sources that say that potential buyers are scouring the books that it’s got to be true.Things are corroborated by five sources so they are right.The “choose by Thursday announce this weekend” is insane.If you chose you announce – and all deals are done on the weekend.So “one source” in the second sentence is either junior and stupid or being misquoted.My guess is misquoted.This sources however doesn’t stick around and the next paragraph quotes another source.

However, another source said the Federal Deposit Insurance Corp. is working in parallel to structure a deal that may allow any buyer to acquire the company without taking on WaMu's toxic portfolio of mortgage securities.

The FDIC would almost certainly be thinking about how they deal with WaMu.The deal that buys the bank without taking on the mortgage book is called an FDIC takeover.It is precisely what happened with several deals where the deposit book was sold.I would lose badly.However I have never known the FDIC to shop a bank without taking it over first.There is plenty of evidence that they do these things quickly and on the weekend – surreptitiously coming into town and even booking hotel rooms for their officers in false names.Besides we know for certain the FDIC is looking because WaMu announced it.

A WaMu representative declined to comment, but a source close to the situation said that there has been no indication by the FDIC of its intentions.

The FDIC does not show its intentions other than asking for information and business plans from the bank in question.This source is almost certainly right.

"If they're running a parallel track, they're doing it without telling the bank," the source said, noting that WaMu's managers do not feel they are operating under a government-imposed deadline to complete a deal. This source added that an auction for the company has been ongoing for five days, and bids have been coming in from multiple parties. The government, the source added, has been watching closely.

Well this has got to be the nub of it.There is unambiguously an auction.The bidders have been saying to the government “you guarantee this and we will buy it”.The FDIC would then (of course) be “watching closely” but would not signal its intentions.Signalling its intentions would be tantamount to giving government money away – and only Paulson seems to feel entitled to do that.

"There's no doubt the government is very interested in what happens to WaMu," the source said. An FDIC representative declined to comment, citing agency policy to avoid comment on "open and operating institutions."

Well there is no doubt the FDIC is interested.WaMu have even confirmed on 8 September when they said:

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank's operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

Anyway back to the article – I think we can safely conclude that the FDIC is watching, not acting and not signalling its intention.We can also safely conclude that the FDIC is not insisting that a deal be done this weekend – but would very much relieved if Warren Buffett were to pony up a spare $15 billion. That is not going to happen – but the deal if it happens this weekend will be a winner for WaMu preferreds because it will NOT involve an FDIC takeover.

Another sell-side source called the situation fluid, and said the FDIC is not communicating with WaMu or its advisers, which include Goldman, Sachs & Co., Morgan Stanley, and law firm Simpson Thacher & Bartlett LLP. Possible bidders reportedly include Banco Santander SA, Citigroup Inc., J.P. Morgan Chase & Co., Toronto-Dominion Bank and Wells Fargo & Co.

This just confirms what I think is obvious now – which is that the FDIC is not forcing this process – but wants to keep informed.It is not communicating with WaMu or its advisors – which means that we are not going to get a FORCED sale this weekend.But the FDIC would love to see a sale.

A source close to the company said the FDIC is looking at the possibility of selling a stake in the company with an option to buy it later. That could not be confirmed independently.

Well of course they would be looking at this.They would happily settle for a deal which says “hey you solvent bank, you chip in $5 billion and you have the option to buy the whole thing within twelve months”.This of course gives WaMu $5 billion now – and that improves the FDIC position.It also improves the position of the preference shares.It does NOT improve the position of the common – but then since when has it been the FDIC’s responsibility to care for common shareholders?

Seattle-based WaMu, weighed down by toxic mortgage loans, has been under pressure from federal regulators to raise capital or find a buyer to restore confidence in the bank.

Journalists puzzle me.I think we got to the point where the Journo clearly believes his source who says that the FDIC has NOT been in contact with WaMu or its advisors.But he is also saying that they are under pressure from Federal Regulators. How can they be pressuring you if they are not contacting you?

I don’t doubt the FDIC would like to see things done – and is clearly in touch with business plans – but the Journalist’s sources here are pretty clear – they say the company is for sale and that the FDIC are not day-to-day forcing the process but they are listening to bids which are requesting an FDIC back-stop.

Concerns about its book of residential mortgages has pushed WaMu's stock to single digits. On Tuesday, it traded at $3.40 a share, down some 92% from $33.54 a share one year ago.

Tell us something that we didn’t know.But then the stock price does the analysis all the time in this business.

WaMu this month replaced longtime CEO Kerry Killinger with Alan Fishman, former president and chief operating officer of Philadelphia-based Sovereign Bancorp. WaMu is the country's largest mortgage lender and, although any buyer would benefit from its 2,300 branches and $143 billion in deposits, there are concerns about an expected $19 billion in mortgage losses over the next 2-1/2 years.

Well this journalist does not do numbers.If losses are “only” 19 billion in the next two and a half years WaMu doesn’t cause anyone any problems.WaMu as I have pointed out many times has 8 billion in pre-tax, pre-provision earnings.19 billion gets neatly absorbed over two and a half years and the capital ratios at the end of the period don’t even look stretched.The problem with WaMu is not 19 billion in losses.It’s the possibility of 30 or even 40 billion in losses.

But most of all I am sure that the Journo knows nothing when he makes statements like ”WaMu is the nation’s largest mortgage lender”.I am not sure that there ever was a time that was true.Certainly most the time the biggest lenders were Fannie and Freddie in that order, and the biggest originator was Countrywide.

The data for WaMu now is that it has almost stopped originating for its own book.In the first quarter of 06 it originated $51 billion total – and less than half was GSE conforming loans.In the second quarter of 08 it originated only $9 billion – and three quarters of this was conforming loans.For all reasonable purposes Washington Mutual has ceased to be a mortgage lender and most certainly is not now the “country’s largest mortgage lender” as our friendly journalist purports. The fact that it has ceased being a mortgage lender tells you there really is liquidity issues here...

Attempts to either inject capital or sell WaMu received a boost last week, when private equity firm TPG Capital waived an anti-dilution protection for its investment in the thrift. The move appeared to be an acknowledgment that the troubled savings and loan may need to raise more than $500 million of additional capital.

On paper, TPG had lost $1.55 billion of the $2 billion it invested in WaMu in April. Its investment came in equal portions from its fifth and sixth buyout funds and from a $6 billion fund it raised this year to make distressed investments in the financial sector, according to a TPG investor.

Ok, we know the situation is desperate though.TPG have access to the books.I don’t.They waived their anti-dilution clause so they are clearly willing to get diluted to preserve some value in their position.That is the real indicator of problems here.The waiving of the anti-dilution clause is however a GOOD thing for the preferred holders.Extra equity capital (diluting but not wiping out TPG) strengthens, not weakens the position of the preferreds. However TPG are also saying "get me out of here" and given that they have access to the books I should not be comforted by that.

In a research report, Keefe, Bruyette & Woods Inc. said last week that WaMu might have enough reserves to weather future losses, but that if the losses intensify it would need new capital that it would find increasingly hard to raise.

That is fill.Its fill however consistent with my thesis.If the losses are “only 19 billion WaMu has enough capital to survive.If more – then problems.

According to one banking source not involved in the sale process, any buyer would face immediate mark-to-market pressures from WaMu's mortgage portfolio. Noting that purchase accounting rules would force a buyer to immediately mark the portfolio to market prices, the banker said that the hole in WaMu's balance sheet upon purchase could be as high as $52 billion. On the other hand, if the bank was not sold, but recapitalized, the hole would be anywhere from $12 billion to $19 billion.

The first sentence gives it away.WaMu is a “sale process” because this journo is distinguishing between people in the know and people like me who are just interested outside observers.[Unfortunately the said journo is not in the know.]

The outside source however has nailed the obvious problem with “buying WaMu” which is that WaMu’s assets are mismarked – and the mismark would be exposed by any purchase.A purchase at a token sum ($1 a share) would solve many of these problems though because there is a lot of “stated capital” left at WaMu even if there is not much real capital.

A deal whereby someone injects equity and retains an option to purchase solves the mark-to-market problem described.That might be the reason that deals are taking the forms stated.A deal where the FDIC warrants that the assets are not going to be $40 billion bad (even with a fee paid to the FDIC) also solves the marking problem.I am not sure whether the FDIC has the legislative power to cut such a deal.

Lots of amazing things have happened in US capitalism in the last ten days. Monday's oil price spike has been lost in the noise. But it looks to have told you something about how hedge funds and oil companies behave.

Global oil consumption is about 87 million barrels per day. US oil consumption is just shy of 21 million barrels per day. At $100 oil that is an 8.7 billion or 2.1 billion dollar per day market.

It would be pretty hard to squeeze the oil market because of its sheer size.

Yet - on contract expiration - the oil price spiked from 100 to 125 dollars - and settled up $20. The forward price was not quite as strongly affected.

Somebody was short. Big time. And they needed to buy back. I have no idea how many contracts changed hands - but to push a 2.1 billion dollar per day market up 25% it had to be an awful lot.

I haven't seen the news that so-and-so-hedge-fund-I-have-never-heard-of has been roasted - but someone looks to have been roasted. And it has slipped without comment.

---

Now here is something to give you less confidence in the Paulson plan.

There was a US organisation with enough oil to meet the price spike and to buy back oil in the one-month forward contract and hence make a LARGE arbitrage profit. That organisation is ... the US Government and the strategic oil reserve.

They only had to sell now, offset by purchased in one month. My guess is that once done the oil wouldn't even need to be moved - you just meet with the liquidator of said hedge fund and settle up.

Ah well - the US government was never much good at trading.

But then we wouldn't normally want them to buy financial assets - and we wouldn't expect them to be able to determine fair value...

Tuesday, September 23, 2008

Last Friday’s FDIC event – the takeover of Ameribank – has given me some thought.

It’s a small bank – it has 8 branches, 112 million in assets and 115 million in deposits.

NPLs were 5 percent June last year.They were 32 percent at year end and 45 percent by June 30 this year.

45% NPLs is what it took to get an FDIC event.

There is much speculation (see WSJ, Calculated Risk etc) that WaMu might be taken over by the FDIC.

Last I looked (ie last quarter) the WaMu NPL over total assets were 3.62 percent, up from 1.29 percent a year ago or 2.17 percent at year end.I am not comparing apples with apples.The NPLs WaMu quotes are against total assets, not total loans – but they are still only in the low 4s.

Now there is plenty of room for NPLs to rise.There are a lot of option ARMs in WaMu’s book –and NPLs have been rising quite consistently and in my view will continue to rise.

But if you take the FDIC on form its not likely to confiscate WaMu soon.It waited more than six months AFTER Ameribank reported 32% NPLs for a takeover.

In the blogosphere I am in a (small) minority of believing that WaMu will probably be OK in the end.I know its gonna get a lot worse.But the FDIC seems to take a lot to act – and I am not sure that that much happens at WaMu.

Then again WaMu might run out funds – and that would force the FDIC hand.So far there is little evidence of that but…

While some people close to the discussions hope a deal could be struck within days, one stumbling block is that a straightforward sale of WaMu would require the buyer to absorb the company's troubled assets.

With WaMu expecting losses of $19 billion on its mortgage portfolio during the next 2½ years, some would-be bidders favor a government-assisted takeover, people familiar with the matter said. One scenario is that the Federal Deposit Insurance Corp. would seize control of WaMu's banking unit and then sell its deposits to another bank.

Now this misses the point entirely. WaMu has 8 billion or so of pre-tax income. Its not growing and capital needs are falling (along with capital). If it has only $19 billion of losses on its mortgage portfolio over the next 2.5 years then hey - its gonna be good. It should of course reserve for the losses now (because well - they are coming). And that reserving would make them insolvent.

But it will reserve them over the next 18 months - and that is tolerable. Every other bank has been spacing its loss reserving - so why not WaMu?

The problem is not $19 billion in losses. That makes it a no-brainer - just buy WaMu at $1 a share and be done with it.

The problem is the possibility that it is $30 billion or $40 billion. That is possible but I believe it unlikely however many readers of this blog have the opposite opinion.

But then of course the Paulson Plan to buy mortgages will save WaMu entirely - if of course they are well connected enough to get Comrade Paulson to buy the mortgages from them rather than whoever buys them.

I guess if Citigroup can get Comrade Paulson to buy the mortgages then Citi can buy WaMu at $1 a share.

What is really funny is that for a bank with adequate capital buying WaMu at $1 a share is a no-brainer. The problem is that there are not three banks with adequate capital to create an auction. That is the state of American banking. You would never know that from Friday's price spike. But that is the smoke-and-mirrors in this game.

As regular readers know I am not averse to bail-outs. The goal however is to get the best effect (ie return of normal lending, normal function of financial markets) at the least cost (bad incentives given by moral hazard).

That is hard. It requires what I would consider “constructive ambiguity”. It certainly requires that the management of the bankrupt institution are replaced and preferably humiliated. [Deny them their golden parachutes.]

The worst bailout recapitalises the institutions without imposing penalty.

And the new bailout plan looks that bad. It plans to buy mortgages from the institutions (thus injecting government money) without a change of control.

The Norwegians got it right – temporarily nationalising most of the financial system – but ensuring the crisis went away quickly. I have linked to the Norwegian history before but I still think it is a useful guide – and one that Mr Paulson should read.

Somewhere last week careful analysis got replaced with panic policy making. The short-selling rule is in my opinion insane and counter-productive. The bailout $750 billion does not contain the main necessary clauses. The government has stopped thinking and started acting.

Saturday, September 20, 2008

This is a little winge – but it also exposes another unintended consequence.

These days financial institutions are much more concerned about their debt spreads than their stock price (though the two are correlated).They would however generally like people who short the stock and go long the distressed debt.

I desperately wanted to do so with WaMu today.WaMu common was trading at 4.25.The preferred was trading at under a quarter par.

I can’t see the common quadrupling from here.But I can see the preferred going back somewhere near par.[That would happen for instance if Citigroup purchased WaMu.]

So I so wanted to do the arb – short WaMu, long the preferred.

I was not allowed and that sucked.

Moreover as the common is liquid my shorting wouldn’t have changed the price much.The pref is illiquid and my going long would lower WaMu’s perceived cost of funds.

The rules (a) denied me a trade, and (b) made it incrementally harder for WaMu in this case.

I have meticulously (and I mean meticulously) gone through Ambac’s reserves (and MBIAs). Ambac is fairly close to accurately reserved. MBIA is way under. Them the facts looking at individual exposures.

That said two things have gone wrong:

1. The bankruptcy of Lehman accelerated some GIC contracts stretching parent company liquidity, and

A small downgrade (one notch) leaves the parent company solvent. A double downgrade requires the insurance regulator to let more money out of the regulated insurance entity to pay parent company obligations.

Be under no illusion – the regulator has an incentive to do this. If the parent company goes bankrupt there is a credit event under Ambac’s credit default swaps. That would accelerate the payment on the CDS – a payment that is currently deferred and may never need to be made if the losses are not as great as predicted on the CDS.

The accelerated payment would mean that the holders of the CDS get paid before the holders of any (future) defaulted municipal bonds. This essentially makes Wall Street structurally superior to Main Street – and the regulator doesn’t like that deal.

Contra: if the regulators hang tough and force the holding company to bankruptcy then the GICs get accelerated anyway – and the money will come from the regulated entity. So the regulator can’t stop it coming from the regulated entity – and might as well not try.

So when push comes to shove (and it might) the regulator will allow the parent company to downstream capital from the regulated entity to the subsidiary.

The regulator will however not allow the regulated entity to set up Connie Lee under those circumstances though – and so a lot of the upside will disappear. Still the question with Ambac comes down to whether they are appropriately reserved not the parent company liquidity. That is the subject of some later posts. Connie Lee comes later.

However just as I thought Ambac’s solvency (or questions thereof) was seriously overplayed the last time the stock was below $5 I think it is overplayed this time.

I am however seriously regretting not selling shares on the way up. Round tripping is no fun at all.

Friday, September 19, 2008

I wake up (jet lagged) and read that the SEC is considering a temporary ban on short-selling.

Ok - just because this is quick-off-the-mark and the SEC hasn't thought it through I thought I might do a little thinking for our pals in Washington.

Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash.

That cash was not available to me - it was pledged to whoever provided the stock to remove or reduce the risk that the stock won't be returned.

That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients).

Now there are a few hundred billion of short-sales out there. Probably more than normal - but a lot in almost all markets.

And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers.

If you ban short-selling those balances will taken away from Wall Street brokers.

That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.

So I conclude that the SEC in their "infinite wisdom" are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.

Its one thing to blame short-sellers for political effect. It is another thing altogether to risk the collapse of the financial system on some dumb-ass policy put up in a panic by incompetent bureaucrats.

Sometimes I worry about America.

John Hempton

PS. I am aware of the limitations on the availability of this cash to brokers. That limitation however differs by such things as the jurisdiction of the client and the arrangements between client and broker.

I am also aware that the SEC does not wish to force short sellers to buy back existing positions - rather just stop putting new positions on. However the effect will not be dissimilar.

If someone can quantify the end effect on broker liquidity I would love to see the model.

But in summary: this is a darn big move with huge financial implications being discussed by the SEC in a panic after meeting with a few congressional officials just before an election. And on the face of it, it will exacerbate the financial crisis.

Wednesday, September 17, 2008

Herstatt Bank went bust in 1974.I was at primary school so I don’t remember.It’s a famous bank bust because it gave its name to time zone risk usually referred to as Herstatt risk.

The problem was that Herstatt received irrevocable payments of Deutsch Marks in the German time zone against a delivery of US Dollars in New York later the same day. Herstatt failed between acceptance and delivery.

Warning – this post is designed to annoy market fundamentalists and the naked short selling crowd…

The main argument against nationalising failing financial institutions at this point comes down to moral hazard.

This is a short post with the idea of turning that on its head.

Debt markets are currently illiquid and highly skittish.

It is alleged that short-sellers are causing problems – but if they are causing problems its not in the equity markets – its in the debt markets.Relatively small amounts of selling of debt can cause a very wide – and possibly self-fulfilling rise in the spread of some financial institutions.

And if financial institutions are going to be allowed to fail you can short their debt with impunity.Drive the credit spread up.The confidence collapse will make you a killing - at least according to Vanity Fair.

But thanks to Paulson et al you can’t do that any more.

AIG proves the government might make the bonds you shorted whole.Anyone shorting AIG debt just had their ass handed to them.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.